Tuesday, May 5, 2009

The TED spread has fallen to just under 80 bps, which is just a few basis points away from levels last seen in 2007. The spread has narrowed recently due to declines in 3-mo. Libor and to increases in the yield on 3-mo. T-bills. That reflects two positive developments: lower Libor shows improving confidence in the banking system, and higher bill yields represent a reduction in the world's desire for safety.

4 comments:

It highlights the issues regarding current market signal improvements as stemming from "healing" or the Fed just plugging the dike. Many of the indicators you have shown are reflective of the Fed/Treasury stepping in directly with capital or purchases.

While this is essential to the survival of the market, it is questionable whether improvements in these measures represent the healing that is necessary to move forward.

If the Fed were to extracate itself from MBS purchases, mortgages rates would surely skyrocket and the housing/mortgage market would be dead. So are tighter spreads and lower mortgages signs of healing?

"Where the Fed is involved, the perception of healing or stabilization can be created. Where they are not involved (corporate markets), continued stress is still plainly visible. In the endgame, credit market investors are smart. They are less emotional than equity investors. We believe many know exactly what is going on and the true character of supposed healing that has taken place with the Fed sticking all of its fingers in the US credit market dike that has cracked and has certainly not been repaired."

There are so many balls in the air I find it difficult to keep it all straight!!!

Scott, I love your blog. It has kept me sane since last year and has made me some money. Not much, I'm only 27, but it made me decide to get into the market at the right time. Anyway, the lords of forecasting at the ECRI agree with you. http://www.businesscycle.com

So, the question is: do all the green shoots we observe represent real improvement, or are they just the result of the Fed shoving money into the system?

I don't see how Fed intervention to date could account for the scope and variety of "green shoots." Fed purchases of MBS, for example, only total about $300 billion or so, but that is just a fraction of the trillions of MBS outstanding. Similarly, the Fed has purchased some $40-50 billion of T-bonds, but that is a tiny fraction of the outstanding. Most of the money injected by the Fed is still sitting at the Fed in the form of unused bank reserves.

The Fed's actions have certainly contributed to support financial markets, because the Fed has fulfilled a vital function: it has supplied massive amounts of liquidity to the system at a time when there was a surge in the demand for liquidity. I think the crisis has clearly passed and the system's demand for liquidity should therefore begin to decline. As it declines the Fed can reverse its liquidity injections and there should be no reason to expect things to collapse again.

In any event, enough time has passed and prices in many markets have adjusted by enough to warrant an improvement in underlying fundamentals even without the Fed's assistance.

Then consider the scope of the green shoots: how can the Fed be responsible for pushing up shipping rates? copper prices? oil prices? The Fed hasn't bought any credit default swaps, but spreads on CDS have fallen dramatically. Volatility in the fixed income market has also fallen materially, and I don't see the Fed trying to or capable of engineering such a feat.

Finally, I would note that there has been a significant increase in the issuance of high-yield and emerging market debt in recent months, and that means that there have been real live investors willing to pay higher prices.

In short, I think there are so many things that have improved, and the improvements have been so uniform and consistent with each other, that it is difficult to argue that it all stems from just one source.

Mike: I usually don't pay much attention to the ECRI indicators, but it's nice when they agree with me. They have done good work in general in the past and I would not want to discount their value. I prefer to put everything together myself, rather than use a mechanistic system such as theirs, but that doesn't mean we can't come to the same conclusions.